- Recent action by the ECB to take interest rates to negative levels are unprecedented but despite these extroardinary efforts the Euro rose.
- The ECB needs to bring the Euro to lower levels because the EU economies are struggling and anti-Euro parties are gaining popularity.
- The failure to drop the Euro means the ECB will have to take even greater steps in fture meetings.
- Gold stands to benefit from these currency wars as ECB easing will be increased and other central banks may fight to also lower their currencies to keep up.
On Thursday June 5th, as many investors already know, the European Central Bank (ECB) cut interest rates to record lows and launched a series of measures to pump money into the sluggish euro zone economy to fight off deflation and encourage economic recovery. For the first time, the ECB will charge banks for parking funds at the central bank overnight in an attempt to force them to lend to small- and medium-sized businesses. In our opinion, the meeting was a huge failure for the ECB and the most important thing that investors can gain from the meeting is what didn't happen - and what that means for the future.
Negative Deposit Rates
While most pundits focus on this negative deposit rate, the folks at The Sober Look don't think it will have much of an effect and we agree. Looking at Euro Area excess reserves we see that they have plummeted over the last few years.
Source: The Sober Look
With lower reserves, a deposit rate cut from 0% to -.1% will not have as much of an effect as pundits theorize. The major effect of the rate cut is psychological and not financial.
What Didn't Happen
The biggest take-away from the meeting wasn't that rates crossed the zero-bound; it was that the ECB wasn't able to push the Euro lower with this unprecedented policy move.
As investors can see in the chart above, the Euro actually strengthened after the meeting - ECB action wasn't able to drive down the value of the Euro.
Make no mistake about it, the most important thing to the European economies and the ECB isn't deflation or liquidity (there is plenty of liquidity in the system) - it is a strong Euro that is wreaking havoc on EU-Zone. The strong Euro makes EU exports uncompetitive in outside markets as their competing currencies are slowly debased by governments such as Japan, China, and even the US (let's not forget the Dollar index is near multi-year lows even as many predicted it would strengthen with the end of QE).
The need for a weaker Euro is even more critical for Europe because of the strengthening of anti-Euro parties that are seeking to dismantle the Euro and return to national currencies. In England, the anti-Euro UKip trounced all the other parties in recent elections, Marine Le Pen's Front National triumphed in France, Syriza did well in Greece, and the list goes on and on. These parties are an existential threat to the ECB and the EU project and recent elections show that their strength is increasing as the European economies weaken - Mario Draghi needs to turn around the economies before it is too late.
The fact that the Euro didn't weaken on the news of the ECB easing is a tremendous failure for the ECB and we think that it surprised the central bank. They can't let this happen again and thus we think that investors can expect even stronger action from the central bank in the next meeting - and we think that it will be a of the "shock and awe" variety.
What Does this Mean for Gold?
Gold's reaction on the news was a sharp rise - but it was fairly muted. Investors bought gold on the news but they didn't do it hand over fist as in the past, and this follows what we've seen in markets recently as gold trade volumes are exceptionally low. But we actually think this may bode very well for gold because long consolidation bottoms are usually made with low volume as bullish events generate little interest - exactly what we have been seeing recently in gold.
Investors should remember that the ECB's push to lower the exchange rate of the Euro is very positive for gold because more easing will ultimately be a cheaper, devalued Euro. That means that large holders of Euros (like central banks and sovereign wealth funds) will need to find an alternative asset to store value, and gold tends to be one of those beneficiaries.
The ECB's attempts to lower the value of the Euro will also generate a response from other central banks as they seek to devalue their own currencies to keep up. Remember we are seeing weak economies all over the world and thus nobody wants to sacrifice their economy by letting their currency strengthen - this is a true race to the bottom as currencies are competitively devalued (just as the Brazil Central Bank chief predicted a few years ago). Weaker currencies are extremely bullish for gold because it is the one currency that will not weaken because of the actions of other - a perfect asset to hold in a currency war.
Finally, and perhaps more importantly, central banks have maintained very strong control over the whole financial system after the near collapse in 2008. This has been very detrimental to gold because the chance of financial chaos in any of its forms (think extreme inflation or deflation), is the best reason to own gold. The more unprecedented measures that central banks take, the greater the chance that someone makes a mistake and loses control and causes a crisis worse than 2008. Investors should not forget that we are truly sailing in uncharted monetary territory - there is no historic precedent or playbook for central bankers.
This is a great opportunity for investors to accumulate physical gold and the gold ETFs (SPDR Gold Shares (NYSEARCA:GLD), PHYS, and CEF) as others ignore them. For investors looking for higher leverage to the gold price, they may want to consider miners such as Goldcorp (NYSE:GG), Newmont Mining (NYSE:NEM), Agnico Eagle Mines (NYSE:AEM), or even some of the explorers and silver miners such as First Majestic (NYSE:AG) or Pan-American Silver (NASDAQ:PAAS). But as we always emphasize, buying gold miners includes many other risks that are not present with owning physical gold, so investors should make sure that they do their due diligence before investing in any particular miner or explorer.
We believe that the political situation in Europe is becoming more toxic towards the Euro and the EU, and the ECB knows this very well, and they also know that they must help the EU economy by dropping the value of the Euro. They failed to do that in this meeting despite taking the unprecedented step of dropping rates into negative territory - they won't fail again so investors should expect even greater easing at the next meeting. Currency devaluation and currency wars are all good for gold, and even though investors are not currently particularly interested in gold (expressed by the declining volumes of trade), that soon will change.
We believe the worst is over for gold investors and the new cycle of easing by central banks signifies the financial crisis is far from over - investors should take the opportunity to buy gold when few others are interested.